Makie asked me to explain what effect negative interest rates would have on the economy. I suppose I have given it away in the title so let me explain what it means and what effect negative interest rates will have on the economy.

On the 7^th October 2015 I explained, on my blog, why there should not be any official interference in interest rates by a Central Bank. The article was entitled “A reappraisal of interest rates and market interest rates”. The reason for this is that official interference by a Central Bank distorts the structure of interest rates and has damaging unintended consequences for the economy such as asset bubbles, funds flowing into unproductive investments, an increase in inequality and many other undesirable side effects.

I was on the margins of the debate in the 1980`s about whether monetary policy should be conducted using quantity of money control or price (interest rate) of money control. It is possible to use either or both but from my point of view there is a very good reason for using only quantity of money controls. These can be managed easily through Open Market Operations and because they do not directly interfere with the price of money they do not create damaging distortions in market prices. I lost the argument and the Central Bank went over, almost entirely, to price of money controls and quantity of money controls, QE (quantitative easing) being an example, were only used in dire circumstances when it was obvious that the price of money controls did not work e.g. after the Global Financial Crisis (GFC).

Why did Central Banks ignore quantity of money controls and support price of money management? One of the main reasons was that quantity of money controls impose considerable limitations on government spending while price of money controls allow government greater freedom to overspend and interest rates can be manipulated to reduce the debt burden. At the time the Bank of England was very much under the control of the Treasury and subservient to fiscal policy.

Despite venturing into QE and not being brave enough to use QT (quantitative tightening) the Bank of England has remained a “one trick pony” thinking that price of money controls are all that is necessary to manage monetary demand. In consequence we have moved from a Bank Rate fluctuating around 5% before the GFC to hovering near 0% at present. More problems have been caused than solved by interest rate manipulation but still the Central Bank sees it as its most important option. Currently the rate is 0.1% so the only option is to go to zero or negative and the Bank is trying to prepare us for a venture into negative territory. Therefore let me now answer the two main questions. What does a negative interest rate mean and what effect will it have on the economy?

Firstly it does not mean negative interest rates for the economy. It will only effect the repo rate which is the rate at which the Bank will repo (sell and repurchase) government securities. At present the Bank will repo government securities at a cost to the cash borrower of 0.1%. A negative rate, of say 1%, will effectively mean commercial banks are paid 1% to exchange their government securities for cash. This will mean that banks will hold more cash which will encourage them to increase lending although this is not guaranteed given previous evidence. Commercial undertakings may adjust any of their interest rates, given risk, amount and term, to slightly lower rates. Credit card rates may even go down from 33% to 32.5% etc.

It is a mistake to think that borrowers will be paid to borrow or savers will be nominally charged for saving. Of course savers lose out in real terms as the result of inflation but this has very little effect on their saving habits. However if savers were clearly told that they are going to make a nominal payment to keep their savings safe then they will start removing cash from circulation and store it under the bed where it will not lose so much value. This will disrupt the monetary system so much that I am confident saving rates will never fall lower than 0.00000001%.

In conclusion the effect on the economy will be more of the same. Asset prices will continue to be in bubble territory as investments, that have the potential for capital gains, will remain attractive and properties that are the source of rents will become the staple pension asset. The structure of interest rates will be further distorted and more money will flow into unproductive assets. If anything economic growth may well dip into negative territory and Central Banks will be continuing to make the mistake they first made when they tried to manipulate rates below the market rate. As I have said many times before the Central Bank should not set an official Bank Rate. However if it continues to interfere in rate setting then we need a rule in place that states Bank Rate must always be at least 2% above the current rate of inflation.

John Hearn 24/9/2020